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An index option is an option to buy or to sell on a stock market index such as the Standard & Poor's® 500 index, the Dow Jones Industrial Average®, the Russell 2000® index or the Nasdaq®. There are two types of index options -- a call, which is an option to buy, or a put, which is an option to sell. When purchasing an index option, an investor is predicting the movement of the market as a whole, or a certain subset of the market. If an investor thinks the market will go up, he will purchase a call index option. If he thinks the market will go down, he will purchase a put index option.
A stock market index is a group of stocks that are selected to represent a broader subset or the market as a whole. The Standard & Poor’s® 500 is an index of 500 large-cap companies that are chosen to reflect the large-cap market as a whole. The Russell 2000® index is designed to reflect the small-cap market. The Nasdaq® index consists of more than 5000 of the most actively traded over-the-counter stocks, and includes many technology stocks. Investors can purchase options on any of these indices.
A call option gives the purchaser to right to buy a particular security at a certain price within a certain period of time. An investor who purchases a call option on a security whose price increases beyond the price of the call will make a profit. Since the buyer of a call is not required to purchase the security, if the price goes down below the call price, the investor can let the option simply expire. In this scenario, the investor loses money, but only the cost of the call option.
A put option is the opposite of a call option. The investor purchases the right to sell a particular security at a certain price within a certain period of time. Investors who buy put options will make money if the price of the security falls below the put price. If the price goes up, the option holder can simply let the option expire, and his only loss is the cost of the put option.
The purchase a call or put option gives the investor the right to buy or sell the underlying security only if the conditions are right. Since only the cost of the option itself is at risk, buying an index option lets an investor ‘hedge his bet’ on the movement of the index itself.